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What are debt consolidation loans?

What are debt consolidation loans?

  • By Saral Credit
  • July 16, 2022

In today's life, having more than one loan account is common. Credit cards, home loans, and vehicle loans are the common loan types that people own to maintain a successful life.

However, there comes a time when you need to find a better way to manage all three loan accounts and manage a single account over multiple debt accounts.

This is where data consolidation comes into play.

What are Debt Consolidation Loans?

A debt consolidation loan is known as clearing multiple credit facilities and opting for a single loan that can clear the existing loans.

It involves taking an additional loan account with a lower interest rate and helps you clear your existing loan accounts. This concludes that you no more need to keep track of multiple loan accounts.

Instead, a single debt consolidation ends the existing loan accounts and brings them under one umbrella. It is a perfect option if you run multiple EMIs to fulfill your dream. 

Any outstanding amount the borrower has yet to pay to the bank is considered a debt.

Debt Consolidation vs. Debt Settlement

Now many of you would mistakenly consider debt consolidation as debt settlement. Interestingly, both these terms are different.

However, both these terms differ to some extent. Debt settlement includes hiring third-party companies who can negotiate with the lender and settle the debt with a one-time lump-sum amount. You are only recommended to hire a debt settlement company if you cannot take adequate actions and have done thorough research selecting a genuine debt settlement firm. Negligence in the selection of the right firm can result in a scam.

On the other hand, debt consolidation includes paying off your existing loans with a new loan. With a new loan amount, you clear all your existing loans and hence end up with a single loan payment. Here the borrower doesn't have to worry at all about the monthly EMIs for different loans. Instead, only one EMI (for a new loan) needs to be taken care of.

Types of Debt Consolidation

Before you understand how debt consolidation works, you must know the different types of loans available.

Debt Consolidation Loan: It is more like a personal loan that is used to pay off all the existing loans. Taking a personal loan for debt consolidation is a smart move to stay stress-free from different EMI payment dates, interest rates, and hassle in managing loan accounts. 

All traditional banks offer personal loans for debt consolidation. Many private players provide the same based on your credit score.

You should always invest time in researching the best debt consolidation loan option. Compare them based on the loan tenure, fees associated, interest rate, etc.

Credit Card Balance Transfer: Some borrowers prefer to take advantage of a new credit card introduced with low-interest rates and other associated benefits. Banks quickly transfer your due amount and reward points onto the new credit card, making it easy to manage a single credit card instead of multiple old cards. 

Before selecting a new credit card, consider important points like transfer fees, transfer deadlines, interest rates, etc.

Student Loan Consolidation: Many students took a loan for graduation and then took another one for post-graduation. This makes a sum of two student loans, creating a mess for them to handle.

Student loan consolidation is the process where both student loans are combined under one umbrella giving you complete freedom from multiple loan accounts and easing the management process. Some of you also know this as student loan refinancing. 

Home Equity Loan: Many prefer putting their home as collateral against a secured loan. Often such loan comes with a low-interest rate. Lenders transfer cash against your home's present value. You can use the cash to clear your existing debts. Once the debts are clear, you can continue repaying your loan against your home.

Getting a home equity loan is one of the best debt consolidation options as it comes with a low-interest rate.

Working of Debt Consolidation Loan

You are already familiar with different types of debt consolidation loans. It's time to understand how this process works. 

A borrower applies for one of the loans mentioned above. Once the loan is approved, some lenders directly pay off the overdue amount of existing debts, while some transfer the loan amount to your account. You can pay the pending amount and close your existing debts.

Once all existing debts are cleared, the borrower has only one loan to pay and manage. While applying for a debt consolidation loan, you can lower your monthly financial burden by extending the repayment tenure. 

Let's understand this with a simple example:

Suppose you own four credit cards that have the following outstanding balances:

  • Credit Card 1: Rs. 20,000
  • Credit Card 2: Rs. 10,000
  • Credit Card 3: Rs. 25,000
  • Credit Card 4: Rs. 15,000

Based on the total calculation, you have an outstanding debt of Rs. 70,000 on all four credit cards. You can apply for a credit balance transfer if you have a good credit score. Under the credit balance transfer, your three credit card debts will be paid with one credit card.

Merits of Taking a Debt Consolidation Loan

There are multiple benefits of getting a debt consolidation loan compared to credit card debts. Below are the benefits you should consider when applying for a debt consolidation loan.

Simply Your Debt Repayment: Handling multiple debts makes it stressful and annoying to some extent. With a debt consolidation loan, you bring all your debts under one hood, making management easy. You don't need to worry about each debt's repayment date and amount.

Fixed Monthly Payment: A debt consolidation loan comes with a fixed monthly payment. This ensures you fix a specific amount to pay for the consolidation loan and clear the debt within loan tenure. It isn't like credit cards that include minimum payment due and total payment due.

Lower Interest Rates: If you have multiple debts, it's obvious your overall debt amount has higher interest rates than the market standards. The best way to settle such an issue is to get a debt consolidation loan that offers lower interest rates. Some debt consolidation loans, like home equity loans, give you the lowest interest rate in the financial market.

Demerits of Taking Debt Consolidation Loan

Many of you are influenced by the merits of debt consolidation loans. However, there are some demerits that you must also note in decision-making. Below are the demerits of applying for a debt consolidation loan.

  • Lenders usually charge you for a balance transfer to a new loan account, closing an old account.
  • You may require pledging your home as collateral (under a home equity loan)
  • You need to research to find a debt consolidation loan with a low-interest rate. Not all lenders provide low-interest rates.
  • With longer repayment tenure, you pay higher interest than the principal amount.
  • It doesn't help you in proper money management. Your approach to money management will remain the same.

Impact of Debt Consolidation Loan on Credit Score

It's a crucial query that most of you would have! Like any other credit facility, getting a debt consolidation loan impacts your credit rating. Every lender runs a hard credit check before loan approval. A hard credit check usually decreases your credit score to a few points.

Moreover, when you use the debt consolidation amount to pay off your existing debts with large overdue, your credit score is again harmed. Ultimately, your credit score is negatively affected.

However, your credit score will gradually improve if you continue repaying the debt consolidation payment on time.

Points to Consider When Applying for Debt Consolidation Loan

A borrower always applies for a debt consolidation loan when they struggle with handling multiple debts. Getting a debt-free life is hard for such borrowers. However, there is an option that lowers their debts and brings them under one umbrella. Debt consolidation loan helps you get some freedom from multiple debts and convert them into a single loan, which is easy to manage. 

Firstly you must check your eligibility for the debt consolidation loan. Based on your credit rating and financial journey, you will get a specific interest rate, maximum loan amount, etc. Moreover, there might be qualifying criteria before applying for the debt consolidation loan. You must know the eligibility! Some lenders prefer borrowers with a stable job that makes them capable of repaying the loan timely.

Once everything works fine, you can proceed with the application and clear the existing debts with the new debt consolidation loan.

Tips for Borrowers Looking for Debt Consolidation Loan

The initial problem for borrowers looking for a debt consolidation loan is to address the real cause of debt consolidation requests. If you are undergoing any financial crisis that has caused the mismanagement and increase of debts, you need to address your issue before applying for the debt consolidation.

Similarly, if you are looking for the debt consolidation that results from credit card overspending, you need to control your problem. The reason is that getting a debt consolidation loan for such issues will double as your overspending habits aren't changed. This will further create new issues that can lead you to become a defaulter.